When filing 2006 corporate tax returns, many businesses will encounter new IRS requirements that significantly affect how they file. Some filers of Forms 1120, U.S. Corporation Income Tax Return, and 1120S, U.S. Income Tax Return for an S Corporation, will be covered by phase two of a mandatory Service electronic-filing (e-filing) program, while others will wrestle with preparing to file a Schedule M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More, for the first time. Even veterans who successfully e-filed last year’s corporate returns and mastered Schedule M-3 will have to adjust to changes in the e-filing transition rules and the requirement to provide additional information with that schedule.
Original Corporate E-File Mandate
Last year, taxpayers with assets of $50 million or more that filed Form 1120 or 1120S, and also filed 250 “other” returns, were required to e-file their corporate income tax forms. (The 250 “other” returns include income, excise and employment taxes, and information returns such as Forms W-2 and 1099.) Taxpayers covered by the mandate used Modernized E-File (MeF), a new IRS filing program, which requires all taxpayers to submit their return data via a single extensible-markup-language (XML)-based electronic transmission.
Many taxpayers found it a challenge to change from traditional return preparation processes to the new e-filing environment. Corporate tax return preparation has always involved retrieving data from multiple sources and systems within a company. Assembling the actual return usually entailed melding data from several separate systems, some derived from return preparation software and some delivered on spreadsheets, Word documents or third-party transaction documents.
The new IRS system requires that all return data (regardless of source) be translated into XML format. Taxpayers may have to modify their internal work processes to ensure that data from their international operations, asset management systems or investment portfolios correctly finds its way into their chosen return preparation software.
Phase one successful: The first phase of the Service’s corporate electronic mandate was deemed a success. Over 500,000 Forms 1120 and 1120S were processed by the MeF system last year, with mandated returns accounting for 14,000 of the total. Much of the initial success can be traced to the IRS’s active engagement of affected taxpayers, return preparers, software vendors and practitioner groups. The AICPA’s IRS Practice & Procedures Committee met regularly with major software vendors and senior Service personnel to identify and address potential problems, leading to a series of transition options that removed obstacles to the e-filing program. Among the most important options were those allowing certain forms to be filed as .pdf documents rather than XML; provided paper or .pdf alternatives for key international forms (Forms 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations; 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business; 5713, International Boycott Report; 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities; and 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships; and their associated schedules); and authorized summary-level data for certain high-volume transactional forms.
Because of some first-year system limits, the IRS also agreed that certain fact patterns would result in a waiver; some corporate forms (Forms 1120-F, U.S. Income Tax Return of a Foreign Corporation; 1120-FSC, U.S. Income Tax Return of a Foreign Sales Corporation; 1120-RIC, U.S. Income Tax Return for Regulated Investment Companies; and 1120-REIT, U.S. Income Tax Return for Real Estate Investment Trusts) were excluded from e-filing.
2006 Return Requirements
For tax year 2006, the mandate expanded to filers of Forms 1120 and 1120S that have assets of $10 million or more and file 250 “other” returns. In October 2006, Large and Mid-Size Business Commissioner Deborah Nolan notified those corporations that, based on the assets reflected on their last return, they were required to e-file under the expanded mandate.
Some taxpayers in this second wave of mandated filers may encounter challenges because of the small size of their tax staffs. In an October 2006 KPMG/Tax Executive Institute survey of tax directors whose corporations filed mandated 2005 returns, 88% said they had incurred either modest or substantial additional compliance costs. Not surprisingly, a majority of the additional expense related to the purchase, training and support costs associated with return-preparation software. For many of those corporations, the costs might have run even higher had their tax departments not had access to in-house technology support for installing and using the software; 86% of the respondents had internal information technology resources to draw on.
The IRS has narrowed the transition options for the second year of the mandate; improvements to both Service systems and commercially available software have reduced the need for some exceptions. For 2006, fewer .pdf forms will be allowed; paper or .pdf alternatives for filing 2005 international forms have been eliminated. A transition option will continue to allow summary data to be entered for certain high-volume transactional forms. Also, in response to privacy concerns expressed by corporate tax directors, the IRS will permit corporate filers to complete Schedule E, Compensation of Officers, without including officers’ names and Social Security numbers; see www.irs.gov/businesses/corporations/article/0,,id=163357,00.html, Section 3.
Another significant change for 2006 returns is that a taxpayer may e-file more than one return. Unlike last year (when only one electronic return per taxpayer was permitted), a taxpayer filing an initial 2006 return and then filing a subsequent (superseding) return before the original or extended due date must now e-file both returns; the same applies for amended returns. (For a discussion of superseding returns, see Keenan, Tax Practice & Procedures, “Superseding Return Filed on Extended Due Date Starts SOL,” p. 236, this issue.)
Waivers: For taxpayers that do not believe they can comply with the e-file mandate, Temp. Regs. Sec. 301.6011-5T provides an opportunity to request a waiver. The taxpayer must demonstrate that either undue hardship or technology issues prevent it from e-filing. The IRS provided detailed instructions for documenting the waiver request in Notice 2005-88. In discussions that preceded the 2005 return filings, the Service predicted that few waivers would be needed or approved, because the transition options would eliminate most significant obstacles. Only 113 waivers were granted for the 2005 tax year, with 48 of those related to entities filing their last required return. The IRS generally did not approve a waiver request if the software purchased or licensed by a taxpayer or preparer did not include all of the features needed to comply with the MeF requirements, taking the position that compliant software is available in the marketplace and taxpayers are expected to obtain it.
Tax Year 2006 Directions for Corporations Required to e-file is an especially useful reference for taxpayers and tax advisers, available at www.irs.gov/businesses/corporations/article/0,,id=163357,00.html. The Service’s website also houses a comprehensive set of continuously updated frequently asked questions. The AICPA’s IRS Practice & Procedures Committee has prepared a presentation that can be downloaded from the AICPA website; visit http://tax.aicpa.org/Resources/Corporations+and+Shareholders/ and click on “AICPA PowerPoint on IRS Mandatory Corporate E-File Program.”
Expanded Schedule M-3 Filing Requirements for 2006 Returns
Schedule M-3 must be filed by corporations and partnerships with $10 million or more in assets, and by certain other partnerships. Filers of Forms 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return; 1120-L, U.S. Life Insurance Company Income Tax Return; 1120S; and 1065, U.S. Return of Partnership Income, are required to include Schedule M-3 with their 2006 returns. Cooperative associations filing new Form 1120-C, U.S. Income Tax Return for Cooperative Associations, must file a Form 1120, Schedule M-3, if they report total assets of $10 million or more.
Schedule M-3 currently contains a line for entities to report any book-tax difference arising from the cost-of-goods-sold (COGS) deduction. However, in pursuit of more detail on how entities compute the deduction, the IRS created Form 8916-A, Reconciliation of Cost of Goods Sold Reported on Schedule M-3, which requires a breakdown of the COGS deduction (e.g., amounts attributable to cost-flow assumptions; book vs. tax inventory computations; inventory shrinkage accruals; and amounts attributable to Sec. 263A costs). The latter must be further broken down into expense items, such as stock option expense, meals and entertainment expense, deferred compensation and depreciation.
Because many companies do not keep records that separately account for the component parts of the COGS deduction, and may be unaware of the new requirement, affected taxpayers will struggle to prepare the form properly during the next filing season.
Mr. Miller is a member of the AICPA Tax Division’s IRS Practice & Procedures Committee. Mr. Dolan, Mr. Keenan and Ms. Markman are members of that committee. For further information about this column, contact Mr. Miller at johnmillercpa@cox.net .
